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Executive Summary

One-third of Americans live in rental housing. Over 40 percent of that housing is “multifamily,” meaning that the housing unit is located in a building of five or more units. Thus, some 12 to 13 percent of the total housing stock is multifamily rental housing.

Access to capital is crucial to the development and upkeep of this housing, just as it is to all American industries. The multifamily industry has a big advantage. The federal government provides these business owners favorable financing by offering federal guarantees on multifamily loans: in 2011, such a guarantee was provided for 73 percent of all new multifamily loans. The combination of these guarantees and artificially low interest rates–compliments of the Federal Reserve–led to an explosion of mortgage debt on the nation’s multifamily stock. The heavy involvement of government-sponsored enterprises (GSEs) in multifamily mortgage finance has distorted the market in ways that may lead to serious future problems if not corrected.

The current federal guarantee of Fannie Mae and Freddie Mac multifamily lending activity poses serious risks to taxpayers and industry participants. The guarantee (1) drives out private competitors by backing loans at uncompetitive low rates relative to private-sector costs; (2) presses guarantors to issue imprudent loans in response to political pressure to increase affordability; (3) increases the use of debt over equity and of debt to finance weaker properties; and as a result (4) exposes taxpayers to risk when the next bottom of cycle hits. The stimulative effects of the guarantee will mask the developing weaknesses until it is too late.

This federal guarantee must be phased out, and the federal footprint in the multifamily lending industry should be restricted to a well-focused role for the Federal Housing Administration (FHA).[i] This paper addresses the concerns associated with phasing out the federal multifamily guarantee and prescribes a detailed roadmap for moving toward a fully private multifamily finance system.

Continue the Status Quo? Arguments defending the mortgage guarantee fail to justify maintaining the risky status quo. First, removing the guarantee will not raise rents: tenant rents are determined by supply and demand factors in individual neighborhoods- not by interest rates or apartment owners’ costs. Second, removing the guarantee would not significantly affect lending to small properties most at risk to be lost to the housing stock as these need additional resources to be viable, resources not provided by a guarantee. Nor would it significantly impact smaller-property lending, as local lenders are competitive. Third, the federal guarantee is not needed to facilitate lending to Low-Income Housing Tax Credit (LIHTC) properties. Prudent private loan terms, described in the paper, would ameliorate any effects of removing the guarantee.

Multifamily lobbying groups argue that their industry must receive government financing. In our view, the industry proposals have little public policy merit and instead are basically attempts to obtain subsidies that benefit multifamily owners and lenders but impose costs and risks on everyone else.

We understand that the recent crisis has left a reasonable fear of future market liquidity, but such short-term fear should not drive the fundamental government policy as other liquidity options are available.

Currently we have a synchronized (rather than locally differentiated) multifamily mortgage market producing excessive leverage for many apartment owners who then are ill-equipped to absorb the potential shock of rising interest rates or declining property prices. This is a formula for future taxpayer losses unless we change course quickly. If we keep on the same path, once again the government will be privatizing gains and socializing losses.

Moving Forward: Recommendations for Reform. Policymakers should follow five key steps to help promote change and reduce guarantee risk to taxpayers and the industry:

Phase out the current GSE guarantees for multifamily housing over a period of five years. This fixed, predictable phaseout would provide the best inducement for private capital to reenter the multifamily mortgage market.

Reduce the multifamily footprint of the other federal actors (for example, the FHA and the Department of Agriculture) to an appropriately targeted role in below-prime lending.

Build on the strength of prime multifamily mortgage loans. Financial institutions should be subject to lower capital requirements for prime multifamily loans.

Privatize multifamily business units of the GSEs but do not include their accompanying portfolios in privatization transactions. Bundling units and portfolios would sacrifice taxpayer value.

Sell portions of existing multifamily portfolios in separate transactions to maximize taxpayer value. This could be done through a competitive bidding process.

Summary of Our Views on the Multifamily Finance Industry

The Last 20 Years Are An Anomaly. Since 1992, multifamily finance has been undergirded by guarantees issued by the GSEs. Investors (rightly, as it turned out) viewed these GSE guarantees as being federal guarantees, thereby converting the multifamily finance market from a market dominated by private capital and private risk-taking into a market dominated by the government with risk borne by taxpayers rather than by investors. This is a degree of federal government support that is unprecedented in multifamily and that is shared by no other commercial real estate class.

The Last 10 Years Are Particularly Anomalous. The GSEs began increasing their multifamily market share aggressively in the early 2000s. By contrast, in the 1992-2002 period, GSE participation in multifamily lending was much less significant.

The Industry Likes This Anomaly and Wants It to Continue. We Disagree. The industry views the GSE guarantees in a positive light because the GSE guarantees have allowed developers and owners of apartments to make more profits than they would have made had multifamily competed for capital on a level playing field. We have an opposite view. We believe that the GSE guarantees have had these undesirable effects:

Over-allocation of capital to the multifamily sector, at the expense of other businesses.

Overuse of debt in the multifamily sector, as opposed to equity.

In particular, overuse of debt in weaker multifamily properties.

Exposing taxpayers to losses when the next bottom-of-cycle hits.

Exposing the multifamily industry to the risk of political meddling in which properties receive financing and on what terms.

Prime Lending in Multifamily Is Safe. In our November 2011 paper, we demonstrated that prime multifamily loans, such as those guaranteed by the GSEs from 1992 to 2004, are low-risk loans suitable for securitization to retail investors.[ii] Appendix C is our definition of prime multifamily mortgage loans from our November 2011 paper. It should be stressed that we use the term “prime” to refer to the loan rather than to the property on which the loan is made. For example, a loan on a newer, very high-quality property in an excellent location could be below-prime if the loan amount is too high. Similarly, a loan on an older, smaller property in a less-desirable location, could be a prime loan if the loan amount and other key business terms are prudent. In the mildly stressful conditions in which multifamily found itself in the 2007-09 period, serious delinquency rates in multifamily loans with GSE guarantees stayed in the 1 percent range or lower. Accordingly, prime multifamily mortgage loans are investment-grade assets with low risk of loss. The same cannot be said for below-prime multifamily mortgage loans.

Below-Prime Multifamily Lending Is Risky. Similarly, in our November 2011 paper we demonstrated that below-prime multifamily loans, such as those made by the Wall Street conduits in the mid-2000s, are on the order of five times as risky as prime multifamily loans. That is, when one moves from strong markets to weaker markets, from newer properties to older properties, from stabilized properties to properties in transition, and from completed/leased-up properties to properties to be constructed, risk does not increase slightly, risk increases geometrically. The same is true when one moves out the risk curve by lending at higher loan-to-value ratios and at lower debt-service-coverage levels. In the mid-2000s, many lenders made below-prime multifamily loans on a nonrecourse basis, with relatively high leverage; these were bad loans by any measure. Traditionally, below-prime multifamily loans have been made with recourse, at relatively low leverage, and only to borrowers with significant other assets. We believe that below-prime multifamily lending should return to those principles.

Why the GSEs Succeeded in Multifamily. We agree with the industry that the GSE multifamily portfolios have been successful and have not, to date, resulted in losses to taxpayers. However, we point out that from 1992 until recently:

The GSEs were able to concentrate on prime multifamily mortgage loans, and for the most part did so (generally using their pricing advantage to obtain a large share of prime loans, rather than to expand into below-prime loans).

The GSE affordable housing goals did not, for the most part, result in pressure on the GSE multifamily business units to loosen underwriting standards. By contrast, the GSE affordable housing goals had exactly that effect on the GSE single-family business units.

The multifamily industry has experienced a sustained boom, with only a mild downturn in 2007-09. The last bottom-of-cycle in multifamily occurred in 1989-91.

Multifamily interest rates have steadily trended downward and today are at an all-time low.

In other words, in hindsight the last 20 years were a very favorable time to have engaged in multifamily lending. Another significant factor is that, in 1992, the industry was recovering from bottom-of-cycle conditions in which both GSEs sustained heavy losses in multifamily. This had two significant effects on the GSEs. The first was that management was very risk-conscious and careful in its multifamily lending efforts. The second was that neither Congress nor the executive branch was inclined to push the GSEs toward more multifamily lending or toward more risky multifamily lending.

Why It Is Particularly Risky to Continue the GSE Multifamily Guarantees Now. We agree with the industry that the GSE multifamily guarantees of the past have not, at least not to date, exposed taxpayers to significant risk. That said, we think that the current GSE multifamily book of business will produce losses to taxpayers during the next bottom of cycle. Potential new GSE multifamily guarantees (going forward) are, however, an entirely different matter, for at least these reasons:

The current GSE affordable housing goals (put in place in the 2008 HERA legislation) are structured so as to put pressure on GSE multifamily underwriting criteria. Thus, there is every reason to expect that, if the GSE guarantees continue, the GSEs will guarantee increasing amounts of below-prime multifamily loans, exposing taxpayers to very large risks.

Absent economy-wide deflation (which would be devastating for multifamily and for commercial real estate generally), interest rates can only rise from here.

There is much more leverage in the multifamily sector today than in 2000. As discussed in more detail later in this paper, we calculate that there was 60 percent more multifamily debt outstanding, per unit, in 2010 than in 2000.

In summary, in 1992, multifamily was emerging from bottom-of-cycle conditions, the GSEs were under no pressure to relax multifamily underwriting standards, and the industry was about to experience an extended boom, in which interest rates would drop dramatically. Currently, all of those factors are operating in reverse.

In Short, Taxpayers Are at Risk. With the GSEs in conservatorship, taxpayers have an opportunity to get out of the multifamily mortgage lending business. If taxpayers do not take this opportunity to stop the GSE multifamily guarantees now, taxpayers will later regret their failure to act now.

It should also be noted that that government guarantees of private loans have a public cost, even if fees charged to borrowers completely cover the taxpayers’ risk of loss. The reason is that the resulting government-guaranteed investment securities compete with Treasury securities, thereby increasing interest costs on the public debt. In our view, this is one more reason to get the government out of the multifamily mortgage business.

Withdrawal of the GSE Multifamily Guarantees Will Return the Multifamily Capital Markets to Their Natural State, Dominated by Private Capital and Private Risk-Taking. Prime multifamily mortgage loans will experience little or no drop in availability but will experience a modest rise in interest rates, to levels currently experienced by prime loans in other commercial real estate sectors. Below-prime multifamily mortgage loans will experience variable availability (good availability in strong capital market conditions, moderate availability in normal capital market conditions, and weak availability in stressed capital market conditions), which we think is as it should be. Similarly, below-prime multifamily mortgage loans will experience variable interest rates (relatively low spreads versus prime loans in strong capital market conditions, moderate to significant spreads in normal capital market conditions depending on loan-specific risks, and very high spreads in stressed capital market conditions); again we think this is as it should be. Said differently, after the federal guarantee is phased out, mortgage financing availability and pricing in multifamily will mirror other commercial real estate asset classes.

In this paper, we will use the term MMBS to refer to multifamily-only mortgage backed securities, and we will use the term CMBS to refer to MBS backed by other types of commercial real estate loans (which may include multifamily loans).

Although no one can predict exactly how markets will respond to opportunities resulting from the removal of market distortion, we do know from all that history teaches us that capitalism and the free market system will effectively and creatively meet the needs of apartment financing once given the opportunity.

1. FHA multifamily reform is a separate and large topic that we do not address, other than to say that (a) we think that the FHA currently has too large a footprint in conventional multifamily finance; and (b) we think that FHA should return to its traditional roughly 10 percent market share, primarily supporting new production of affordable rental housing.